Option Writing – Are the Risks Worth the Rewards?

While there is much interest in trading equity and index options, it is also a well-publicized fact that the vast majority of these options expire worthless. If so, the obvious way to trade these options must be to be a seller, rather than to be a buyer. There are many services that present this view to the public. Many even go so far as to make the individual trader feel like they are then on the side of the professional by being a seller. Indeed, selling options is part of what professionals do, at least the professionals who make a market in these derivatives, and traders you use spreads for income. However, the pitfalls of selling options are not often made clear enough. Option selling can be a worthwhile approach, but the many pitfalls should be clearly understood before engaging in this activity, or the result could be financial damage to one’s account far more serious than anticipated.

By most estimates roughly 80%, give or take a little, of options expire worthless. With odds like that it is no wonder that being a seller of options is so enticing. But do they really give money away that easily on Wall Street, or in the case of many options, on LaSalle Street? What about the other 20% that don’t expire worthless? With a large chance of success but a small profit objective, and a small chance of loss with essentially unlimited loss potential, the problem becomes evident. The risk reward on a short option sale, or naked short position, has an out of balance risk vs. reward ratio. Brokerage firms picked up on this imbalance in risk and reward and initiated very high margin requirements if one wishes to engage in the dangerous activity of naked option selling. And rightfully so. If they had been more lax in their margin policy, many more firms and traders would have been insolvent in times of major market dislocations.

However, the lure of capturing the options premium with a high probability of success is still intriguing. After all, nature of an option is that of a naturally wasting asset. The possibilities seem well worth investigating. If only there was a way to hedge that small chance of the market causing serious damage, or worse, wiping you out. And there are many ways to hedge this risk, but this is usually beyond the scope of those simply doing covered writes. When I began trading there were no option exchanges. Option trading was handled through private dealers who could make a market any way they wanted on individual securities. They were the sellers. The public bought. With the advent of the CBOE and other exchanges offering option trading, it became practical to apply many of the spreading techniques long used by professional option dealers and many futures traders.

A spreading technique is one of the ways to avoid a catastrophic loss on a short option position, as there would be an offsetting long option position in place to limit the loss. This also greatly reduces the margin requirement. In the early days of option trading on the exchanges, brokerage commissions and bid/ask spreads were very high. But that didn’t stop many books, option software programs, and option strategy seminars from promoting hypothetical and complex strategies trying to capture the premium of a decaying asset, with some sort of protection. There were calendar spreads, butterfly spreads, spreads of every imaginable combination in an effort to make a profit on a delta neutral position, or a position not relying on calling market direction. There were also many more spreads to do if you were bullish or bearish. These techniques were viable for members on the floors of futures exchanges, but its viability at the time were questionable for the retail trade with high commissions, difficulty establishing the complex spreads, and with limited liquidity.

Being intrigued by all these possibilities, and with the PC just coming into use, I entered a massive amount of option data into spreadsheets in an effort to test these theories. It was an exhaustive task. I first tried to find a delta neutral approach that would show a positive return on an annual basis over several years of data. After months of testing I could not find one combination of spreads that could beat a risk free Treasury bill rate of return. And when I would add in commissions and bid/ask spread, every combination turned into a loser. I didn’t even factor in slippage. The books and seminars had the right basic concept. The problem was the execution and costs. (Today many of these problems have been minimized.)

I think many other traders were coming to the same conclusion, as the game began to shift to selling only combination of both puts and a calls naked, that is with no protection. The trader would sell a put a strike or so under the current price of the underlying asset, and simultaneously sell a call just over the market, and would collect the premiums on both these sides, and then hope the market didn’t deviate too far beyond those strike prices. It was most common to only write these combinations out a month or less. Suddenly a whole crop of seminars and money managers were engaged in this activity until that game blew up during the 1987 market crash, causing great harm and bankruptcy to many traders and institutions. The need to have protection against the short option position should be clear.

Another strategy I see many people doing is to sell puts on stocks they want to own anyway. If the put gets exercised you are forced to buy the stock. At least with this strategy, even thought it is usually a naked short sale, there is some downside protection because a stock can’t go below zero. If you sell a call naked there is no limit to the loss as the stock can go as high as it wants. Often after a sell-off in a stock or index, the put premium will be puffed up, so there is a chance to sell an overvalued option which will surely deflate its premium and further deteriorated if volatility decreases. If forced to buy the stock, this premium will also reduce the cost a bit, even thought the stock is now probably being held at a loss. The other side of the coin is if the option is not exercised and you are right about the direction of the stock movement, you might only have received a dollar or two for selling the option, while the stock climbs ten or twenty dollars with you not aboard. However, if your market timing skills are excellent and you sell the put and can still jump on board the stock or go long calls, with the put premium paying for the calls. I’ve seen this as a workable strategy with some advantages over the covered write. If you sell the proper put option, you basically have an identical risk graph as the inverstor who buys the stock and sells the call. You still have the difficulty of knowing what to do with a falling stock if you get exercised just as you would a covered write. But one advantage is that you have a market imposed time frame as the option will expire. With the covered write you still own stock and it is all too easy to hold that declining stock after the call expires, and often being too far underwater to continue writing additional calls. This can happen with a naked put if exercised, but psychologically less likely. Rigid risk control is a must.

A similar stategy to the covered write, but at lower cost and with the advantage of the market imposed time limit, would be the long term calendar. This is similar to the covered write as the trader would still sell a call option. But instead of owning the actual stock at a high cost, the trader would simply buy a long term call option that is in the money. This can reduce the cost significantly. It is true that the long term option will decay in value over time, but it will decay at a much slower rate than the near term option that is being sold. This can be turned into a campaign if the option being bought is very long term, such as a leap. As the near term option that is being sold expires, the next months option can be sold to bring in more income. One thing that has to be watched closely is the volatility level, as a collapsing volatility can depress the long option and reduce the profit potential of the trade.

The ideal covered option writing strategy would be in a stock or other asset where you could define a probable range where the asset it is likely to trade, and have that range not exceeded, therefore not endangering your long position from being called away. And, it would also be preferable for the asset to be volatile enough to create a sufficient premium to make the transaction worthwhile. These two conditions are not always present at the same time. When a stock is trading sideways and volatility is low, the option premium is usually too low to warrant selling. If you owned a $50 stock, why would you want to limit the upside potential if the only option you could sell would be for 50 cents? That might be all you could get on a sideways, range bound stock. But volatility is cyclical and if the stock breaks out of its range and moves to $60, you’d be forced out at the strike price of $50. But worse, if the stock breaks to the downside and goes to $40, the 50 cents you received for the call option sale is not much of a cushion. As a result you are stuck with a losing long position. If you still want to hold the stock at a loss, any additional calls you might write at the new lower price would probably insure a loss on the stock if called away, and it would likely be a loss larger than the premiums you took in. In my opinion there are many strategies to employ with a stock or index that is not trending strongly that are superior to the covered write, but they require more knowledge and attention than the simple buy write.

On the other side of the coin is the option that has a very volatile underlying stock. Take another stock at $50, but this time there is an option trading at $5. That’s a 10% premium (leaving out any intrinsic value for sake example) and it seems very worthwhile to capture this excessive premium. Obviously there are many option buyers who think the stock will surpass $55 before expiration or they would not be putting on the trade. You reason you can buy the stock at $50, sell the option at $5, and have downside protection to $45. Of course you will capture that entire $5 premium at expiration no matter what happens to the underlying stock. If the stock stays at $50 you would have the best situation, as you will be most likely be able to write another call and repeat the process. But if the stock is volatile enough to cause such a high premium the odds are not high of that happening. What if the stock goes to $60 or $70? Do you exit the whole trade before expiration? Has the option premium decayed so you still have some profit, or has the volatility increased so you have to buy back the short option at even more of a loss than the intrinsic value. Do you wait until expiration and tie up your money in a boxed in trade where there is little to be gained? Do you take a loss on the short call option, hold onto the stock, and hope the stock keeps going higher? With human emotion as an element, it is likely many traders would cover the option just at the wrong time. Legging in and out of spread positions is usually a bad idea. And where do you put a stop on the underlying stock if it starts to decline?

Sometimes the greatest option premium occurs after a stock has topped out and had its first correction, and tries repeatedly to re-test the highs, thus increasing volatility. Many traders who missed the move will be tempted to buy on the correction, thinking another leg is in the works. This can create much volatility and expand the option premiums temporarily. A high volatility, but sideways channel can seem to be forming. This can seem ideal for a covered call writing campaign. It can be lucrative to sell these options, but keep in mind that the stock has a good chance of giving up the battle and selling off sharply very quickly, especially if the preceding run has been a long one. These high volatility channels are often topping formations and do not last. Many gains from selling the options repeatedly can be wiped out by one sharp and fast down move in the stock. It isn’t easy psychologically to exit the long position in the underlying stock when you’ve been in a successful option selling campaign and all the analysts are still talking the stock up. Once the stock is out of favor, with the perception that the move it enjoyed is now yesterday’s news, the option premiums tend to deflate. You are then left with a stock showing a loss, with only lower priced options available to write, and if done will surely lock in a loss if called away at the lower strike prices.

I have found that using covered call writing as a trading approach or strategy in the long run will result in a portfolio of poor performing stocks for most investors. This shouldn’t be the case and doesn’t have to be with strick money management rules. But the average investor lacks rules and discipline. The good stocks will be culled out of the portfolio, thus leaving a portfolio of losers where further call writing will be on successively lower option premiums, and if hit will lock in a loss. There may be times when a short-term correction is anticipated and one doesn’t want to lose position in a stock, so it might be prudent to sell call to gain a little additional income on a short term trade. But usually not. To be successful, one has to have nearly perfect timing skills and great discipline. If one possesses these skills I would think one would be better off trading the stock or index outright as a net long or short position, or using any one of the many directional option spreading strategies available such as butterflies or calendars. For short-term trades that are not exposed to excessive option premium decay trading the options from the long side would at least have the risk vs. reward ratio favorable.

Certainly there are times when a covered call writing strategy will work out well. But in the long run this strategy can eliminate the winners and and cause the investor to hold on to the losers, exactly the opposite of the correct way to trade or invest. There are several mutual funds that use covered call writing as the central theme of their strategy. If this approach had merit there should be some evidence of superior performance from these funds in both up and down markets. Many of these funds under-perform in both up and down market, and essentially all of them under-perform in up markets.

The basic idea of selling and option to take in the premium of a wasting asset is basically a sound idea. But there are pitfalls. It is usually a bad idea to be short an option without a hedge by either having long options against the short positions, or long stock, or at least enough cash in the account to cover a short put. Short calls without a hedge can cause bankruptcy in a hurry in a strongly trending market. Selling option premium against long stock is not the only game in town. There are many strategies that can capture decaying option premium with much less risk, cost, and probability of profit. The downside is that they require more active participation in the process, and a lot more knowledge.

3 thoughts on “Option Writing – Are the Risks Worth the Rewards?

  1. Your are right. The ability to know when the market is stable and sideways is critical to option selling. The real way to make money selling options by selling via non-directional strategies.

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